Modern retailers and real-estate developers are now legally challenging the government notification to impose service tax on rentals imposed in the last budget. On Thursday, a writ petition was filed in the Bombay High Court under the aegis of the Retailers Association of India (RAI), the Multiplex Association of India (MAI) and the Confederation of Real Estate Developers of India (CREDAI) challenging the move.

Economic Law Practise, a large legal firm has been roped in to argue the case on behalf of the retailers as a detrimental move on the business profitability. Retailers had made a representation to the government in April07 in an attempt to persuade the government against the move. Gibson Vedhamani, president of RAI was unavailable for comment.

However, sources close to the development said the petition was filed in the Bombay High Court. The educational cess on services has also been increased from 2% to 3%, taking the total service tax to be paid by the developer or the property owner to 12. 4% of the rental income. Technically, service tax on rentals will have to be borne by landlords who lease out space to retailers. Currently, over 90% of the modern formats are leased by retailers. However, several lease agreements hold a clause which states that any additional tax or levy will have to be borne by the lessee. In a typical retail format, rentals are almost 6-7% of revenues and are increasing every year. In the last two years, realty prices have zoomed multifold. Retailers would now have to incur higher operating costs.

To add to this, the fiscal budget 07-08 imposed service tax on rentals. Thus land/mall owner (lessor) would obviously try to pass on the new tax burden to the retailers (lessee). This imposition of service tax though is an additional burden on the retail companies coffer but the dent would not be the same for all retailers. The impact on operating level margins comes out to 50-70bps. It seems difficult that these retail companies would be able to pass this tax incidence to the customers.

Retail companies, who had identified the boom in the Indian retail well in advance, had already locked in properties at a rate much lower than the current prevailing prices in the market. Hence companies like the Future Group, Shoppers Stop, will not see an immediate impact on the margins, however, companies who are on a land amassing spree would be the ones who are hit higher. All in all the net impact for the next two years would be less than 2% on the EPS. If the government wants to curb the inflation, this is not the right way. In fact, I feel it may further add to inflation said a top developer in Mumbai said.

Rentals are now expected to touch over 15% of sales from around 7-8% in previous years and retailers are worried over the losing margins further. Globally, rentals constitute 3-4% of sales for retailers and no service tax is charged on rentals, industry officials said. The rush to secure prime locations has led to unrealistic expectations by mall and real estate developers. To deal with the pressure, several malls have begun moving into fixed rental and profit/revenue share to reduce pressure. The ratio of rentals for anchor tenants to regular tenants is also expected to go up from 1:3 to 1:10.

The cost of occupancy in India is one of the highest in the world with industry sources say it is cheaper to set up shop in the U.S than lease space in India. Rentals in developed markets like the U.S is around 3-4% of sales. A senior official in a south based retail chain said the tax is meant to be a second tax on income and not really a service tax.

The cost would be significant especially for small format retail like ours. The imposition of service tax on rentals from commercial establishments, announced in the Union Budget recently, is causing consternation amongst the landlord-tenant community. The initiative is bound to squeeze the margins of small and medium retail traders as there will be no opportunity to offset the taxes against output taxes as they cannot be offset against the State value added tax, according to industry chamber FICCI.